Michael has been a student of markets and market structure, for nearly 30 years. His proprietary research into the shift from actively managed portfolios and investment funds to systematic passive investment strategies has been presented to the Federal Reserve, the BIS, the IMF and numerous other industry groups and associations.

Michael joined Simplify in April 2021 after serving as Chief Strategist and Portfolio Manager for Logica Capital Advisers, LLC. Prior to Logica, Michael managed macro strategies at Thiel Macro, LLC, an investment firm that manages the personal capital of Peter Thiel. Prior to Thiel, Michael founded Ice Farm Capital, a discretionary global macro hedge fund seeded by Soros Family Management. From 2006-2014, Michael founded and managed the New York office of Canyon Capital Advisors, a $23B multi-strategy hedge fund based in Los Angeles, CA, where he established their global macro strategies, managing in excess of $5B of exposure across equity, credit, FX, commodity and derivative markets.

In addition to his work as a market theorist and portfolio manager, Michael has been noted for his work as a public speaker and financial media participant. He is a graduate of the Wharton School at the University of Pennsylvania and a CFA holder.

With a wealth of experience as a market theoretician and a prolific contributor to financial discourse, today’s guest is uniquely positioned to guide us through the complexities of index fund dynamics. Joining us to discuss the problems that passive investing may be causing in financial markets (and what people should do about it) is Michael Green, Chief Strategist and Portfolio Manager for Simplify Asset Management. Tuning in, you’ll learn about the ramifications of the surging popularity of indexing and the sobering reality of mounting market inelasticity, backed by compelling evidence that underscores the challenges facing today's financial landscape. The insights in this episode extend beyond mere observation, with Mike offering policy recommendations and strategies to address the structural issues affecting our markets. While this conversation is certainly challenging, philosophical, and even alarming, it isn't purely theoretical. It’s a call to action to safeguard the integrity of our financial systems. So, be sure to join us as we navigate the nuances of indexing and passive investing at large, guided by the expertise and foresight of one of finance's most respected voices!

Key Points From This Episode:

(0:05:48) The negative effect that the growth of indexing is having on financial markets.

(0:07:37) Insight into the XIV trade that strengthened Mike’s belief in this view.

(0:13:49) Defining the problem that indexing is causing (which might seem like a good thing).

(0:15:57) How market cap-weighted index funds differ from closet index funds.

(0:16:57) Indications that markets are becoming increasingly inelastic over time.

(0:19:21) Why flows into cap-weighted index funds differ from the overall aggregate of active.

(0:24:21) Active versus passive investing in public versus non-public markets.

(0:25:57) The catastrophic event that could be caused by index funds (and how to avoid it).

(0:30:51) Why we need to rethink the definition of passive investing and the value of diversity.

(0:36:10) Market inelasticity versus inefficiency and the impact of active manager performance.

(0:41:38) How investors should shift their strategy to respond to the current market structure.

(0:53:01) Regulatory recommendations: who actually needs to step up and do something.

(0:54:30) Mike’s outlook on US expected returns, market volatility, and 401(k)s.

(1:01:50) Why Bitcoin isn’t the solution to all of our monetary and fiscal policy problems.

(1:05:22) The definition of success in Mike’s life (and why it’s completely non-financial).

Read The Transcript:

Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We are hosted by me, Benjamin Felix and Cameron Passmore, Portfolio Managers at PWL Capital. 

Cameron Passmore: Welcome to Episode 302. Today we have a very interesting and thought-provoking, philosophical as well, guest. Someone that both you and I have followed for a long time on Twitter. It's Michael Green. Online he's known on Twitter, at least, as @profplum99. Mike is the Chief Strategist at Simplify Asset Management. He’s a prolific researcher and writer. This is an incredibly thought-provoking, alarming, for good reason, and I think this is an important topic for us to understand, as best we can. But it's so interesting.

So, Ben, why don't you give a bit of the backstory, as Mike said, get this, “We're possibly setting ourselves up for the worst financial experience of all time.” There's all kinds of caveats to that. But if you just accept that as the point of the conversation and try to understand it, it is absolutely fascinating.

Ben Felix: Mike is some of that I've been peripherally aware of for years because he's written a lot and speaks a lot about index funds causing some real big fundamental problems in financial markets. And because we often talk about index funds being a good thing, I’ve often been sent to stuff like, “Have you seen Mike Green's stuff? Have you seen Mike Green’s stuff?” So, I didn't really take the time to dig into it until about a year ago. Started reading his writing more seriously, listening to him on other podcasts, watching the presentations that he'd done, and really started to get what he's talking about as the problem.

It's important to say that he's not saying this collapse is coming. It's not a doomsday proposition. It's just structurally, these are the problems that are being created in financial markets right now. There's a chance we get a really bad outcome, that could be disastrous, maybe. Not necessarily a prediction that it's going to happen tomorrow. But in terms of the distribution of outcomes, Mike thinks that there's some bad stuff that could happen based on the way financial markets are working right now, largely due to the growth in index funds.

So, we wanted to make this episode a place where people could listen to once, because it took me a while to really get what Mike was talking about. We wanted to make this a place where people could listen once, get the issues, get the arguments, see where Mike is coming from. I think he raised a lot of really interesting points. He's brilliant to talk to, speaking with him, keeping up with something.

Cameron Passmore: But the solution is so difficult and so politically challenging. The narrative on index funds is so powerful.

Ben Felix: This is the thing that I find really difficult to think about, is that Mike is raising potentially valid issues, and articulating them very clearly. So, you take it all in. It's like, okay, there's potentially a real problem here. What do we do about it? We talked about this with Mike during the episode. For the average investor investing in Vanguard funds, nothing. You keep investing in index funds. Individually, there's nothing anyone can do other than maybe exercise their democratic power, I guess. But even then, like you said, Cameron, no politician is going to run on a platform of shutting down index funds. It would be a disaster for that politician.

So, there's this potential problem where index funds are growing, making financial markets more fragile. Investors should still continue investing in index funds, potentially even more so because as Mike talks about in the conversation, it actually gets harder for active managers to beat the market as index funds grow. But at some point, as Mike says, the adults in the room, someone has to do something, or the fragility of markets could cause a real bad outcome for a lot of people. Again, Mike's not saying that's going to happen tomorrow. He says during the conversation that this problem, inelasticity of markets due to index funds could drive valuations up, way higher than they are now.

So, it's basically a matter of, at the individual level, you shouldn't do anything about this. You don't go and start investing in actively managed funds because of the problem Mike's describing. You keep investing in index funds. If you want to beat the market, you lever up because you can't beat it, other than by increasing your beta. Someone has to fix this eventually. But it may not even be in our lifetimes that the bad outcome actually happens. I don't know. Philosophically, it's a very hard thing to think about and I think Mike did a great job laying out the issues that he sees and the arguments and how he arrived there. But in terms of what to do, and Mike does give us a slide deck that we can reference, and that's on slide 32 in the deck that people can see some of his kind of policy recommendations on where do we go with this. I think Mike would agree. It's not easy to fix.

So, people can listen to this episode. Hear Mike Green's arguments on the problems that index funds may be causing in financial markets and what people should do about it, which at the individual level is not much, which is not what you expect when you hear him describe the issues.

Cameron Passmore: Pretty good setup. With that, let's go to our conversation with Michael Green.

***

Ben Felix: Mike Green, welcome to the Rational Reminder Podcast

Mike Green: Thank you for having me, Ben.

Ben Felix: Super excited to be talking to you. All right, can you explain what effect you think the growth of indexing is having on financial markets?

Mike Green: So, what you've done is you've increased the proportion of market participants that are truly valuation insensitive, or price insensitive is another way to think about it. As a result, what you've done is you've actually increased the inelasticity of the market. The ability for prices to change in response to relatively small changes in supply and demand. That's really the primary dynamic. You removed that historical filter in which investors would react to higher prices by saying all else equal, the information content that I've now received is that future returns will be lower. Therefore, I'm more willing to sell.

For passive investors, you actually receive the opposite signal. As the price goes higher, relative to other securities, it becomes relatively more attractive. It's presumed that there's inflammation content there. As a result, you actually allocate more capital to those names that have gone off the most.

Cameron Passmore: What does the ultimate bad outcome for this issue look like?

Mike Green: Well, unfortunately, the way this plays out is that it looks like things are getting better and better and better and better. It's very much like the turkey, Taleb’s turkey before Thanksgiving, where it looks like it's most robust, where it looks like it's most richly valued, where it looks like the opportunity set is greatest is right before – actually, you end up seeing a net redemption that plays the whole thing in reverse. This makes the market much more fragile in both directions. That's really the definition of inelasticity. A market that reacts, a price level that reacts much more violently to small changes in supply and demand.

Ben Felix: Okay, perfect. That's what I was going to ask you to clarify. When inflows are going in, that's having an upward effect. And when they go down, it's going to have an exacerbated downward effect.

Mike Green: Exactly. Correct.

Ben Felix: Can you talk about the XIV trade that strengthened your belief in this view?

Mike Green: Sure. So, XIV had a couple of different components to it and I just want to be very cautious and saying it's not a direct analogue. The rules around say the S&P 500 or broader market indices. It didn't exist for the UX futures, for example, or for the VIX itself. This is another really good example of exactly that type of dynamics. So, you had the XIV was an inverse VIX ETF. In other words, every time the VIX went down in price, it would go up in price. It really was more tied to the carry components associated with the VIX curve.

So, as forward volatility was priced at a premium, because you're selling high and then buying it back low, you're riding down that curve. There was a huge positive carry associated with that short volatility position. What was interesting about this was as the price of the VIX pushed lower and lower and lower, the XIV price was obviously being pushed higher and higher and higher. Most people are wired to look at a much higher price and say that represents a good thing. That means it's safer. That means it's in better shape. Things are going better. But because it was an inverse product where 100% decrease in price could occur on a doubling in level, that became mechanically easier and easier, the lower the VIX got in price itself. And really, it's more UX futures. The VIX futures is compared to the VIX, which is not really a traded instrument.

But the same underlying factor remained the same. The lower the UX futures got, the higher the XIV became. Ironically, the easier it became for XIV to go to zero. Now, the market mispriced that. It was the simplest way to put it. So, what I recognized was that under the conditions of crowding that had occurred, that the potential for a spike in the VIX on a relatively small change in the S&P had become magnified. The options pricing failed to take that into account.

The easiest way to think about it was in mathematical terms. The distribution of XIV itself became very bimodal. So, it wasn't like a normal option, which the most likely outcome is something near to its current price. It actually turned out that the higher went in price, the most likely outcome was that it went to zero. I actually figured that there was roughly a 95% chance it was going to go to zero over the course of two years. As a result, the option pricing should have been modified to reflect that. It's really hard to do. So, recognizing that mispricing, we were able to put a fairly large position on and ultimately, it ended up playing out the way that I thought it would.

Ben Felix: Market has become less elastic because of the index fund issue, and that caused XIV to be mispriced or to have mispricing affecting its performance. You saw that traded on it and it worked out.

Mike Green: Worked well. Yes. That’s the easiest way to put it. It is important for people to understand that there's always extenuating factors. So, just like I would not say that it was 100% probability that was going to go to zero, there is roughly a 95% chance of the probability of it going to zero, and that was being driven by a couple of factors. One was the growing reliance on the market itself, to express trades in a short volatility manner. I would actually characterize that as very similar to the growing reliance on the market that passive investing is “safe”. That it’s the right choice for most people to make.

In the aftermath of the global financial crisis, there were regulatory changes around how much capital you had to hold against different types of trades. So, if you wanted to sell CVS for example, in the aftermath of the global financial crisis, that was obviously very risky. Nobody sells CVS, and so you needed to hold a whole bunch of capital against it. If you wanted to express a long equity position as an investment bank, in particular foreign investment banks, you had to hold relatively high capital positions against that, for the very obvious reason that we’ve just seen equities fall significantly. So, you wanted to be protected against that potential risk. 

There was a notable arbitrage that existed in the capital regulations around short volatility as distinct from long equity. And the two you can think about the VIX tends to behave inverse to the S&P. It's actually quite straightforward to hedge a long S&P position with a short VIX position. It’s a relatively standard and relatively straightforward implementation. The Volcker Rule components what was called the CCAR provisions, had a huge mismatch between the capital that was required to be held against the short-vol position and the capital that was required to be held against the long-equity position. As a result, the street, and then once again, in particular foreign investment banks, UBS, Credit Suisse, Bank Peridot, et cetera, gravitated their exposures to expressing trades in short volatility manner.

On February 2nd, 2018, the Fed changed those rules, and it dramatically increased the cost of holding short volatility positions. As a result, on February 2nd, knowing my positioning, I started getting calls all over the place from banks saying, “Hey, would you be willing to sell volatility to us?” I'm massively long volatility at this point and saying, “Well, that's a super interesting request. First, the answer is no. And secondly, what is actually going on?” That actually is really what caused Volmageddon, was a regulatory change that was unexpected and unanticipated that caused the scramble to buy volatility. That in turn manifested itself was the start of a spike in the VIX complex, the UX futures as those banks tried to buy back that exposure, and then the mechanical implementation of XIV kicked in. Because once you had a large enough move, the volume that needed to be rebalanced within the systematic strategies like XIV are really my position was expressed on something called SPXY. Those actually took over and the market collapsed under the weight of its own illiquidity.

Cameron Passmore: Wow.

Ben Felix: Man, crazy stuff. Beyond the XIV that we just talked about, what other evidence do we have that index funds are causing a problem?

Mike Green: When you define a problem, the problem is typically thought of as a bad outcome. But for the most part, so far, what we're seeing with indexing is a good problem. It's forcing prices upwards. It's causing markets to become more richly valued. That in turn is leading to perceptions that saving is a great thing. People are putting more money into these strategies, and that in turn is causing prices to rise even further.

So far, there's no problem, just like XIV represented a magic money printing machine that attracted people into all sorts of investment strategies around short volatility. Unfortunately, there's a point at which you get so high, again, the Taleb turkey-type framework, that a relatively small and seemingly inconsequential event can start to magnify itself in the exact same manner we described with the XIV. So, the problem that has occurred, or the problem that is beginning to become quite apparent to many people, particularly those who are following this very closely, is that withdrawals or money coming out of a market is always a function of the asset level.

As you push values higher and higher and higher, and you concentrate the resources in vehicles, like the Vanguard total market index that carries no cash whatsoever, it's a $1.6 trillion fund that carries $80 million in cash. If an active manager were to come into your office and say, “We're running a $1.6 trillion fund with $80 million of cash”, you would throw them out of your office and say, “Don't ever talk to me again.” That's completely irresponsible. But we look at that with Vanguard, and we're like, “Oh, yes, of course, this is the safe way for people to invest.” So, the problem occurs when people try to take money out. When they try to take that money out, Vanguard has no choice but to turn to the market for that liquidity. The scale of these entities are now at the size that just like the XIV, you could actually cause yourself to exhaust the order book and a crash to commence.

Cameron Passmore: Well, I have a market structure question for you, Mike. How are our market cap-weighted index funds different from closet index funds or large institutions with very low tracking error budgets, which have existed for a long time.

Mike Green: In some ways they're not. But remember that a closet tracking fund always has the discretion to say, “Yes, we're not going to do that.” One of the untold stories in the crash of ‘87 was that the losses were actually born by the clients of Leland O'Brien Rubinstein, which was the firm that developed portfolio insurance. So, their rules were very straightforward. When prices fall, you sell futures to Delta hedge your underlying exposure. As prices fell, they needed to sell futures. As prices fell more, they needed to sell more futures. At one point, Mark, Rubinstein's trader came to him and said, “Mark, if we make this next sale, we will send the market to zero.” Mark said, “Don't do it.” That discretion is important and it doesn't exist in the passive vehicles.

Ben Felix: Somewhat similar to that question, how do we actually know that markets are getting less elastic over time? Maybe to ask it a slightly different way, how do we know that index funds have less elastic demand than whoever the counterfactual security holder was in the absence of index funds?

Mike Green: Well, so part of it is actually answered your own question. So, you just asked me about the dynamics of what's the difference between discretionary index trackers and systematic index trackers. By definition, somebody is less elastic if they can't change their rules. We actually know that to be the case. Now, the academic community has done a tremendous amount of work on this. You're familiar with the work of Valentin Haddad, for example. How competitive is the stock market? We've talked through these dynamics before. They are identifying that the market itself has become increasingly inelastic.

Now, I could share with you a couple of slides, some of which are actually quite dated. One of the interesting things about the presentation that I shared with you, is very few of these slides have actually changed in any meaningful way over the years. But one of the slides, I’ll just draw your attention to slide 14, which shows you the market's reaction to fundamental events on earnings reports, we're seeing a significantly greater level of price change associated with earnings reports. I have kept this chart in part because I love the description on it, that it's showing against an average. Something that's clearly trending is being shown against an average, as if it's going to somehow mean revert in the future.

I don't think that's the case, obviously. I think that it's becoming less elastic. Again, I would encourage people to check out the work of Valentin Haddad, which is on slide 15, talking about these underlying dynamics of market capitalization, relative to elasticity. Their tests show that the largest companies, those that make up the top of the S&P 500 or the Nasdaq-100, paradoxically, are the least elastic. And as they become larger and larger, and the index becomes concentrated amongst those names, the indices themselves, the markets themselves are becoming significantly less elastic.

Ben Felix: I can't remember it's from their paper or from talking with you, but the intuitive explanation of that is basically that anyone who cares about tracking relative to an index has to hold those largest stocks, so they're going to be less elastic.

Mike Green: Right. That is the easiest way to think about it, is if I buy the S&P 500, theoretically, I could statistically sample and say, “I don't really need Delta Airlines. It's not a very big company. It's not going to have a meaningful impact on the index. But I have to own Microsoft. I have to own Apple. I have to own Nvidia.” 

Cameron Passmore: Why are flows into a cap-weighted index fund different from flows into the overall aggregate of active which obviously holds the market?

Mike Green: So, first of all, that's not obviously true. The second part of your statement that all active managers match all passive managers in aggregate, is an untrue statement that's predicated on the idea of fully complete markets with no regulation that doesn't have requirements around diversification, et cetera. That's honestly just a misframing of the reality that, unfortunately, gets repeated over and over and over again.

Look at some of the most successful investments until very recently would be entities like the Tiger Funds that were very active in non-public equities. There's non-public equities. There's non-public real estate. There's non-public companies. There's non-public debt. None of those can actually be represented within the indices. So, it's really quite disingenuous. Actually, use the language of Bill Sharpe and say that they’re just the same thing, because they're not. The second component is that it's not really so much that you're waiting on the basis of market capitalization, although, that does have a disconnect. This is again, under the academic work of JP Bouchaud, who showed who highlights that liquidity does not scale with market capitalization. It scales with volume and volatility.

The market cap is only peripherally related to volume and volatility. If I looked at the number of shares and quantity of trading from Microsoft, for example, relative to Delta Airlines, while their market capitalizations are roughly 100 times different, their trading volumes are only about five times different. That's actually a by-product of market structure, how trading activity actually occurs. If I'm a market maker, I have to put capital up against trades to facilitate those trades. The profitability of that capital is determined by the spread between the bid-ask and the quantity of shares that are being traded. If there's only five times as many shares being traded on Microsoft, and it has a tighter bid-ask spread than Delta Airlines, then it's less profitable for me to put capital up against Microsoft in proportion to its market capitalization.

As a result, it actually becomes less liquid, or more inelastic is the easiest way to think about it. When you try to shove through trades in the size that you have to for a market cap-weighted index, it overwhelms and actually causes those names to rise more than they otherwise would be expected to.

Ben Felix: You explain it well. I do want to mention, I was just emailing with Valentin. He's going to come on to talk about his research later this year.

Mike Green: Fantastic. Valentin Haddad's work is great. There's only one major error that he made, which is the assumption of 15% market share for passive vehicles. So, if you actually properly scale his work on the basis of the far higher share of passive that you can derive from the work of Marco Sammon and Alex Chinco, the academic community is starting to rapidly recognize these underlying characteristics, then you actually come pretty close to the right answers in terms of the impact that it's had. It's just Valentin didn't do that, because he didn't realize how large passive had become.

Ben Felix: The Marco Sammon paper you're talking about, that's where they measure passive based on trades, right?

Mike Green: What Marco Sammon and Alex Chinco did, this is actually in response to a challenge that I gave them as I was reviewing another of their papers, where they had made a similar statement as to Valentin Haddad in terms of the share of passive. They alluded to it at 15%, simply adding together the share of State Street, Vanguard, and BlackRock, basically. I challenged them and said, “No, that's wrong.” The reason it's wrong is it's missing all of the things like separate accounts that are mimicking, certain extent, Cameron's question. So, you have separate accounts that mimic. You have collective investment, trusts, commingled investment trusts, CITs, I'm sorry, I'm blanking on the name of them, that represent a sizeable fraction, but are not captured under traditional mutual fund 13 Fs. You have individual corporate exposures. You have total return swaps. You have futures. Option trades on the indexes, et cetera. All of these are ways in which indexes must be used at a far higher scale.

So, to come back to the point on the Alex Chinco and Marco Sammon paper, the way they chose to test this was they went and they looked at what fraction of shares had to change hands and were traded on index reconstitution events. So, this is the most restrictive definition of passive index tracking, those who trade within the very first day of an index reconstitution. Their conclusion is the number is somewhere around 35% hit that hardest definition of passive. If you expand it to a five-day window, it climbs to about 45% passive.

Ben Felix: That's a cool way to look at the past for sure. It makes sense.

Mike Green: Well, we know it's not 15%. We wouldn't be sitting here talking about it if it was 15% because it's become so omnipresent within the industry. It's one of these challenges where the entities that are most directly involved, the Vanguards, BlackRocks, et cetera, are being very disingenuous and their presentation of information.

Ben Felix: I want to ask more about that later. I want to come back real quick to the flows into aggregate active versus passive. We asked our podcast audience what kind of questions they want us to ask you, and this was one that a lot of people said they really wanted to hear you talk about. If we forget about non-public active, does that change anything?

Mike Green: I'm not sure what that means.

Ben Felix: Well, you said it was disingenuous to frame it that way because there's lots of assets that are non-public and can't be included in an index. But if you just look at aggregate active public markets, does that not look kind of like passive?

Mike Green: Not really. Again, it boils down to the regulatory framework. So, there's something on the 40 Act, which I know you're deeply familiar with, that governs the amount of diversification that's required within funds. The index providers are largely exempt from those requirements now, due to the effects of lobbying the SEC to obtain exemptions, things like the S&P 500 growth fund, or even the Nasdaq-100, really, at this point are far too concentrated to qualify for what's called diversified fund status. Technically, they shouldn't even be bought by anyone other than accredited investors. They shouldn't be buying these things, but they can buy them with a click of a mouse.

Likewise, if you want to flip that around and take it even a step further, we're now enabling people who have never obtained a margin account, never actually obtained option trading authorization to replicate that type of experience by using things like triple-levered ETFs. We allowed the markets to become far more risky while pursuing a theoretical ideal of complete markets. Candidly, I think that we're ultimately going to pay a penalty for it.

Ben Felix: One of the things that came up when we were talking to our podcast audience about this is you just talked about the penalty, is there going to be a bad event where there's a lot of volatility or is it something worse than that?

Mike Green: So, unfortunately, I think it's something worse than that. I wouldn't be out here raising the alarm if I thought the problem was that we'd see a 4% correction in the S&P. Who cares? That's not the issue. The issue is that we have effectively allowed a system to persist that mechanically inflates valuations, endures us to that process, allows us to create all sorts of narratives around both why it's happening, and what the degree of wealth that is being created is, and then, we rely on that wealth for our future consumption expenditures.

So, when you have an aggregate, something like a baby boomer demographic, or a passive penetration strategy that starts to run in reverse, and the passive investors become net sellers and require liquidity from the market, the market can't provide it. That's the XIV event. Unfortunately, when you run the simulations around how this plays out in the S&P, it looks very much like the Chinese stock market crash in 2015, in which the market fell 85% in a matter of months.

Ben Felix: So, not just a little bit of volatility. That's a permanent decline.

Mike Green: I mean, the real risk is that you just end up shutting the markets. I realize that sounds insane. But remember that you have 100 million Americans and an untold number of people around the world who believe that their deposits in the S&P 500 are safe. Take that away from them, they try to take that money out, and suddenly the world changes in a quite dramatic fashion.

Ben Felix: What about stuff like, this is an off-the-cuff question, but like circuit breakers and markets, does that help any of this?

Mike Green: Hundred percent. Absolutely. Circuit breakers, that's part of the reason why I highlighted that at the start. The behaviour of the S&P would be almost certainly quite different than the behaviour of the XIV which could fall 85% to 90%, 95% in a single day. That's obviously not possible with the S&P. But the problem is, is that you create the dynamics of a bank run, and a bank run effectively can only be solved by shutting the bank.

Ben Felix: That's wild. So, we've talked about the S&P 500 just now. How big of a deal is this in other countries? Like we're in Canada. Is the TSX exposed to the same kind of issues?

Mike Green: So, it's not as much, and this is kind of one of the interesting features. If you look at the behaviour of US markets and you look at the market share gain, one of the charts that I would draw people's attention to, and we're going to skip around and you'll have access to the full presentation, and I encourage people to check out other podcasts where I've given the full presentation. But I just want to show you a very quick chart, which is slide 11. How does the market transitioning from active to passive behave? The chart on the right-hand side, actually, shows the exponential feature of the growth of passive strategies and how that actually becomes an exponential curve in terms of rising valuations.

The reason why that matters is because, when you think about the US, which had a head start in passive investing in as far further along in passive investing than any other market around the world, this helps to explain why we ultimately continued to gain share versus the rest of the world. While the rest of the world is moving towards passive and is adopting it, their share of passive is lower. As a result, it's a red queen effect from Alice in Wonderland. They're running really fast to try to just stay in place. We're running just a little faster. So, we continue to gain share relative to global market capitalizations, even though our GDP really doesn't suggest that that should be happening. There's a lot of debates around the quality of the companies. You're looking at antitrust lawsuits against each one of our largest entities, and yet we continue to price them more richly than ever.

Cameron Passmore: So, how does systematic firms like Dimensional or Avantis that tilt away from CAP weights fit into these dynamics you talked about?

Mike Green: They're playing a slightly different game. When you think about what's ultimately happening with strategies like Dimensional Fund Advisors, where they're engaged in systematic value strategies, is really what they're well known for. It actually turns out that really what that is, is just a volatility sale. So, it's a portfolio construction technique where you agree in advance that you're going to sell stuff that goes up, and you're going to buy stuff that goes down. 

Mechanically, that's the same thing as saying I've sold call options, and I've sold the put options. I should capture a premium associated with that volatility short. This is why the value factor is so closely correlated with short volatility in general, when volatility spikes, the value factor tends to underperform quite significantly. They're interesting and that they have different exposures. I do want to emphasize, I don't have it in this presentation, I have it in another one, I could send a copy of it afterwards. If you wanted to share the slides, you could. But remember the part of what you're looking for in a robust market is diversification in terms of the participants.

Actually, there's nothing wrong with a passive strategy, a “passive strategy.” I do think it's actually really important. Let me pause for a second and just make sure that your investors or your listeners understand what the academic definition of passive investor is. The academic definition of a passive investor is somebody who never transacts. They simply hold. If you actually read the original literature behind the idea of passive investing is put forward by Bill Sharpe and his 1991 paper, ‘The Arithmetic of Active Management’, which is what Cameron's referring to, when he talks about all passive managers are the same as all active managers. Again, I don't think that's actually true for reasons I've talked about.

But the part that's equally less true is the idea that passive investors can simply hold because they can't. They have to get into the market and they ultimately have to get out of the market in order to realize their gains. As a result, there is no such thing as the academic definition of passive investors. It's so perverse that in Bill Sharpe’s paper, in footnote number four, it actually refers to transactions theoretically happening in the liminal hours when the market doesn't actually exist.

That's awesome. I mean, a little bit of magic in your life is a wonderful thing. It's not a great thing in your expectations for retirement. But it's a wonderful thing in thinking about markets. I would actually go so far as to suggest we've kind of hit that Arthur C. Clarke point where any sufficiently advanced technology is indistinguishable from magic. You ask most people how markets go up, “Oh, it's kind of magic. It just happens.” That is really the definition of passive investing. That was highlighted by Lasse Pedersen in his 2016 paper called ‘Rethinking the Arithmetic’ or ‘Sharpening the Arithmetic of Active Management’, in which he noted this footnote number four, and said, “Hey, wait a second on index reconstitution,” this is exactly the Marco Sammon approach, “they have to transact.”

My observation was something slightly different than that and I pushed Lasse hard on this. He fully acknowledges it, that passive investment, as we define it today, transacts every single day. Vanguard takes in about a billion and a half dollars every single day. That is a large hedge fund every single day. So, the idea that they're not transacting in the market, that they are somehow passive investors is prima facie absurd. What they have been is contributors of liquidity to the market by providing an investment philosophy that says, “If you give me cash, thank you for the billion and a half dollars every single day, then buy.” What should I buy? Everything. What price should I buy it at? Whatever the last idiot priced it at.

Ben Felix: That's interesting. So, that's basically saying that Bill Sharpe ignored flows. 

Mike Green: Absolutely.

Ben Felix: You talked about Dimensional and Avantis, what about non-cap-weighted index funds more generally? I don't know, fundamental weighting or –

Mike Green: I’m not even sure that really exists. But again, you're just talking about slight variations on it. So, if I equal weighted, am I removing some of the misspecifications on liquidity versus market cap? Sure. But I'm replacing them with others.

Ben Felix: Okay, that makes sense.

Mike Green: The real issue again, and just go back to the diversification component, it's hugely valuable to have people transact for different reasons. You may want to buy a house, therefore you sell. I may look at a valuation and say, “Well, that's too high. Therefore, I'm going to sell.” Somebody who has even more conviction may say, “Wow, that valuation is so crazy. I'm going to short it and synthetically make more shares available for people.” That's what shorting really is. That diversity creates robustness within the market. Really, all we're describing with the growth of passive and more importantly, the regulatory support for the growth of passive, is that we're effectively narrowing down the diversity and heterogeneity of the marketplace and making it more and more homogeneous into a group of strategies that basically boiled down to, did you give me cash? If so, then buy. Did you ask for cash? If so, then sell.

Cameron Passmore: Interesting.

Ben Felix: The regulation is, I can’t remember what it's called in the States. The qualified whatever it is, the auto-enrolment?

Mike Green: Slightly differently. So, under the Pension Protection Act of 2006, we switched 401(k)s from opt-in frameworks. In other words, you had to choose to participate to opt-out frameworks. In other words, you had to choose not to participate. That was a substantive change in the market that was done under lobbying from primarily Vanguard and BlackRock. 

The second key change was the designation of qualified default investment alternatives. So, if you're going to default somebody into participating, you have to put them into something. It actually turned out that the vast majority of people or not the vast majority, but many people, when they chose to participate in their 401(k), would look at the plethora of choices available to them and say, “Man, I have no idea,” and just hold cash.

So, the QDIA changed that. It started to force people into the market and therefore led to far greater participation. Interestingly enough, when that was done in 2006, that led to the explosion of the growth of firms like PIMCO, that could manage balanced funds that combined bonds and equities into a single product. That was then replaced as the Qualified Default Investment Alternative, QDIA in 2012, by target date funds. Today, I want to say the number is somewhere in the neighborhood of 95 cents of every retirement dollar in the United States now flows into a target date fund.

Ben Felix: Wow, crazy. We talked about this on Twitter a while ago. The issue that we're talking about, the elasticity issue that index funds create, how is that distinct from market efficiency?

Mike Green: So, this is actually really interesting dynamic, because this is one of those things where the academic definition can really pollute the underlying information set. The academic definition of efficiency is effectively how much of the price change can be explained by the release of fundamental events. So, information is released, the price changes. If the price changes a lot than actually the market is theoretically quite efficient. If the market doesn't change, or if the security doesn't change in a substantive way different from the market, in other words, you need to think about the behaviour of a security as being idiosyncratic in its relation to things like an earnings release, and systematic in its relation to behaviour with the market. So, perversely, the definition of efficiency is when there's not information released, it behaves very much like the market. When information is released, it behaves very differently than the market. 

The irony is, is that by making securities less elastic, or more inelastic, you're actually increasing the responsiveness to those fundamental events, which can lead to the confusing articulation of the markets are becoming more efficient. Things that we look for, things like post-earnings announcement drift, are one of the metrics that are used to measure efficiency. Well, those are diminished if the reaction to an earnings report is the stock rises 100%. The proportion of movement that's tied to post-earnings announcement drift becomes smaller and smaller.

Now, most people are beginning to wake up to this and say, “Wait a second, it's not at all efficient for the stock price to rise 50% on a trillion-dollar market capitalization on an earnings report.” Clearly, there's something wrong with the efficiency in terms of information diffusion that's going on. Most people are starting to wake up to that. Most people are starting to recognize that it's not efficient for a company to triple or quadruple in its price post-bankruptcy announcement. We're starting to actually say, “Hey, wait a second, that's a stupid definition, even if I understand why you arrived at it.” Now, we're actually starting to recognize that markets are becoming less efficient, even as that elasticity is leading to many of the academic measures of efficiency to be like, “Hey, nothing's ever been better.”

Ben Felix: One of the other big measures is active manager performance. How does this situation affect the ability of active managers to beat the market?

Mike Green: Perversely, what it does is it creates a drift in the marketplace that penalizes holding cash or being “safe,” maintaining the optionality of cash. But it also perversely corrupts measures like the Sharpe ratio or alpha in its behaviour. Again, jumping to a slide, and this one has to be a little bit interactive. I apologize to your listeners. If you jump to slide 25 in my deck, this is titled, ‘When time becomes a proxy for passive penetration, alpha vanishes for active management’. What I'm pointing out here is that the historical model of how stock prices behave or how markets behave, is that there is a central tendency, equities return 8% a year and then there's cyclical variation around that.

When you introduce something like passive, this is the pale blue line, the convex curve that you see. When you introduce something like passive, it pushes valuations up over time. It actually changes that underlying return function from a flat line to a convex line. Now, this is where it gets really tricky, and I apologize for your listeners if there is math involved. The solution sets that we use in finance, we're all very good at math. But alpha is actually just the intercept on a linear equation. The behaviour of your portfolio is equal to its beta times the market return, plus some idiosyncratic measure we call alpha. Y equals MX plus B.

If you use a linear solution to a curved surface, over time, mechanically, your alphas get pushed lower. It's just math. It's a function of the fact that we're really not as good at math, as we like to talk about being. We're just using the wrong metrics. So then, if you flip to the next slide, you can actually see the impact that this has. The theoretical model, you're looking at alpha in this context, and the impact of passive, is identical to the empirical data.

Ben Felix: Alpha is going down.

Mike Green: Because of the growth of passive. It's not because active managers have a harder job or because there's fewer idiots out there, et cetera. There's plenty of idiots. Just look at GameStop. But what we're actually experiencing as a market that is being distorted from the growth of passive. As that becomes larger over time, it creates this exponential curve of rising valuations, that in turn forces mechanically the alphas lower for active managers, which causes us to fire the active managers because they're idiots, and replace them with the oh-so-efficient passive investing, which further exacerbates the problem.

Ben Felix: Man, active management is getting harder as indexing grows. Harder to generate alpha.

Mike Green: Right. The exact opposite of what most people think.

Ben Felix: It’s wild.

Mike Green: It is wild.

Cameron Passmore: So, how should, or should investors change their strategy in response to this current market structure?

Mike Green: Well, this is where it gets really hard, Cameron, because what we're describing as the same phenomenon as the Chuck Prince soliloquy and the lead-in to the global financial crisis. I just showed you, it's impossible for active managers to beat passive, and it becomes harder and harder as passive gains larger and larger share.

So, the answer is you invest passively. But that then exacerbates the societal risks that we face, when ultimately, we try to take that money out. The answer is, it's unfortunately, not your clients’ responsibility to say, “Hey, I want to make less money than my peers. I want to save less efficiently for my retirement.” The music is playing. We still got to dance. But that is the societally, significantly less than optimal response to these underlying conditions.

So, it really unfortunately relies on the grownups in the room. I would include RIAs, and asset managers, and investment advisors to begin to communicate this and candidly, Vanguard and BlackRock should be taking the lead and saying, “Oh, man, we've really screwed this up. We need to start unwinding this.” But their paycheques depend on not revealing that information. So, we're really trapped, unfortunately.

Cameron Passmore: Their paycheques rely on things being the way that they are, but their paycheques are going to go down if the market crashes 85%. Why wouldn't Vanguard and BlackRock want to do something?

Mike Green: Well, the simple answer is, one, I just don't think people at Vanguard are that good. It's a cult organization. And so, I'm not convinced that Vanguard really understands this. Although, I know for a fact that individuals within their organization do know some of these elements. BlackRock, I think, is a little – let's just be honest, they're true capitalists. They just want to make money. I think part of the irony is, is that you're starting to see the signs that they are aware of this. What does Larry Fink come and done? He's replaced his ESG fixation with, “Americans are not saving enough for retirement, we should adopt the superannuation systems of Australia.” That's possibly the only system that is more aggressively moving passive than the US system.

So, what he's really saying is, “I, Larry Fink at BlackRock, want to do the same thing I did in the aftermath of the pandemic. I want to be tapped by the US government to manage all assets. I want to solve the high-yield problem. I'm going to be the guy who's tapped to go out and buy all this sort of stuff.” Even more attractive than managing 15% of a market that is up 100% would be managing 100% of the market that’s down 85%. That's a great gig.

Ben Felix: Just on the topic of active strategy and being able to beat the market with the way that it's set up now. Is there anything cross-sectional like momentum? Or I don't know, is there a way to measure elasticity and select securities based on that?

Mike Green: No, it's super interesting. I mean, guys, you and I both know, Ralph Koijen at Chicago, he's developing some tools and systems that allow you to effectively predict the behaviour and elasticity around individual securities. I have a ton of respect for the work that he's doing in that area. Others, I think certainly are aware of this. So, part of what you're referring to is almost like the Andrew Lo Adaptive Markets hypothesis. People are going to respond to this.

Unfortunately, the easiest answer is, “Hey, I just recognize that this is happening. I can't stop it and therefore I become I'm even more venal in my prosecution of it.” A really simple example of that would be the nonsense around SMCI and its inclusion within the S&P 500. Among the most profitable businesses out there, for the multi-strat hedge funds like Millennium or D. E. Shaw or others, is index inclusion arbitrage. And so, recognizing that something like SMCI having exceeded the 12 and a half billion-dollar threshold for the S&P 500, was going to be included in the S&P 500. They're able to buy as many shares as they want, effectively pushing it further into the S&P 500, and guaranteeing themselves exit liquidity when the event occurs.

That's one of the strategies that works. The other one I would argue is that the public is starting to wake up to the dynamics of momentum and “technology” in the same way that they did in the late 1990s, where a similar phenomenon happened. Cameron, this actually goes back to one of your points. We used to have market cap-weighted indices. We don't, actually, just to be very clear. We have float-adjusted market cap indices. The irony is that the dot-com was version 1.0 of this dynamic. In the 1990s, the unique features of the market where you had companies that had gone public, that were relatively large market cap, but had many of their shares held by insiders. Companies like Microsoft, Cisco, Dell, et cetera.

There was a very substantive change in the passive rules and regulations in 1994, where they moved from trying to statistically sample or buy every individual share, to increasingly relying on futures for replication. That shifted the problem away from the risk of Vanguard having tracking error to the dynamics of tracking error existing in futures merchants who refused to accept it, because that's where their profits are generated from. That meant that every time that you went in to buy shares of Microsoft in proportion to its market capitalization, you were effectively trying to buy twice as many shares as would otherwise exist. We used to call this the insider ownership effect that led to outperformance as the single best-performing factor from roughly 1995, soon after the adoption of those dynamics. Until 1998, when of course, people started awakening, like, “Hey, wait a second. It's not really insider ownership that matters. It's technology.” It turned out that the single best correlation to insider ownership was a relatively recent IPO. So, the street began to manufacture all sorts of these things that people suddenly wanted. We call them technology IPOs. That's what the dot-com cycle was.

Now, perversely, we're at the same stage, we bought ourselves capacity by changing the markets from cap-weighted to float-adjusted cap weights. But now we've exhausted it. So, we're seeing the same underlying behaviour, and people are, of course, waking up and saying, “Hey, this whole value thing, boy, that was stupid. I should be a momentum investor. I should be a technology investor. Just get me some of that sweet, sweet AI stuff and I'm going to be rich like Croesus.” Right now, ironically, all they're doing is accelerating the termination point. But that's what's underway right now.

Cameron Passmore: So, you're a portfolio manager. How do you incorporate your views on passive into your investment strategies?

Mike Green: That's one of the wonderful things about adaptive markets. In the past couple of weeks, you've been treated all sorts of individuals who have identified different ways to do this. David Einhorn who I spoke with and identified these with. He was one of the early people I spoke to. Figured out that he was going to approach markets in a totally different way than I chose to approach them. This has worked out really, really well in some ways. My view was very straightforward, that you ultimately wanted to stay exposed to the large-cap indices that you wanted to participate in this, and candidly, if you can, you want to actually leverage that exposure.

So, doing things like buying call options, which historically had delivered significantly negative returns, now actually largely offer positive returns, because the market has shifted in that drift feature. That would be one way that you incorporate it. You embed long-term or you embed call option-type strategies that capture elements of this drift and are candidly not properly priced for those underlying dynamics.

The other way that you identify this or you deal with this is you recognize that the information content that we're receiving on the health of the economy, and the health of individual securities is actually wrong. It's being corrupted by these underlying dynamics. That's trickier because it effectively requires you to start saying, “Where do I start to bet against this? Where do I think this starts to unwind?” Now, my models would suggest that what this largely means is that markets are increasingly reliant on employment, that contribution from 401(k)s, and ultimately, that you start unwinding this process. Again, it is really tricky because there's multiple levels to thinking through how this plays out.

One way in which markets have continued to power higher is people have started saying, “Well, I don't want to buy the Vanguard total market index. I don't want to buy a total market index. Just buy everything.” Cameron's observation of I’ll just mimic the entire market. So, they're now cheating. They're starting to buy the technology funds again, and they're starting to buy the momentum funds again, and they're starting to focus on certain areas of the market, effectively concentrating their firepower.

The great irony is, as we look at a fantastic year, like last year, or we look at a year like this year in which the S&P is, I think, up somewhere in the 10% neighbourhood, forget where it is, after yesterday. Today, we're just totally reversing it. But when you actually start thinking about that, and you concentrate that firepower that can push markets higher, even as the median stock is actually down this year, and was for the vast majority of last year.

Ben Felix: People are loving the technology.

Mike Green: Look, it's a natural component. We're a narrative species. You've asked me on to the show because I have a compelling narrative. If I had an uncompelling narrative, you'd be like, “All right, that's a crazy guy sitting on a corner.” But because I have a compelling narrative, you want people to listen to it. As a species, we gravitate to compelling narratives. We believed, for thousands of years that the sun transmitted the sky, pulled behind the golden chariot. It's not unrealistic to tell people that the reason why stock markets go up is because they can't go down. Certainly, feels that way. Once you tell them, they can't go down, then they start trying to figure out, “Wow, how can I gain more wealth relative to everybody else? You know what, I'm going to buy the stuff that goes up the most because that can never go down even more.” Who knows?

Cameron Passmore: That's an interesting question, actually. I want to ask more about the US market in general later, but just on tech, do you think that tech stocks have done well, because tech is doing well, or because of this whole index fund problem we're talking about?

Ben Felix: What a question.

Mike Green: So, I think there's a mixture of the two. One of the other components that of course comes out of this, is if you recognize that what I'm saying is, is that markets are less elastic than we think they are and there's an entire paper written on this in 2020 by Gubaix and Koijen called ‘The Inelastic Market Hypothesis’. So, I'm not adopting any unique language or anything else.

But if you accept that there is more friction from flows than the theoretical models would suggest and just to parameterize that for individuals, the work of Gubaix and Koijen suggests that $1 into the market on average creates about $5 of market cap. The theory of efficient markets under which we rely on for the insights of passive assumes a dollar into the market because somebody had to sell you those shares, only creates one penny of market cap.

So, Gubaix and Koijen would tell us that we've misspecified our theoretical models that underpin the growth of passive by 500 to 1. Now, my math says is much worse than that, actually. But that is pretty bad measure. That's not even good enough for government work as I like to joke. 

Cameron Passmore: Crazy. That's back to the Sharpe thing where the arithmetic of active management makes sense, unless you account for flows. Now, we're saying that flows are even more impactful than what people thought previously. Yes, super interesting. You mentioned briefly that RIAs should be communicating this, and you mentioned the adults in the room. Who actually fixes this? Who needs to step up and do something?

Mike Green: This is where I hate to say it, but the answer is, unfortunately, regulation. So, at the tail end of the presentation, I've got a series of recommendations for individuals or for regulators. The simple reality though, is it's not going to happen. Because Vanguard and BlackRock spend more on lobbying than all of the rest of the industry combined. They control the regulatory apparatus at this point. They are the “good guys” because they're facilitating savings at very low cost and it's worked out brilliantly so far. As a result, they have a degree of mindshare that is almost impossible to overcome.

Ben Felix: It's a crazy situation.

Mike Green: It is a crazy situation. Now, you understand why I'm so passionate about it.

Ben Felix: Yes. I started understanding because I started reading your stuff, and then it's worth people hearing. One of the crazy things, though, from the individual investors perspective, and you said this earlier is that other than recognizing that it is a societal problem, they shouldn't do anything. The best thing to do is continue buying index funds.

Mike Green: Yeah, that's exactly right.

Ben Felix: That's wild.

Cameron Passmore: It is.

Ben Felix: I want to ask about US expected returns. US markets have been on this crazy run for the last 20 years. I hear people all the time saying that the US is going to keep getting 10% returns forever. The other thing people say it's crazy is who cares what the US market? Look at QQQ it's going to keep getting 14% returns forever. What's your outlook on US expected returns?

Mike Green: First of all, that's that complex, adaptive phenomena that you're talking about. So, a decade ago, nobody would have talked to you about QQQ a little bit longer than that. Twelve years ago, if you remember David Einhorn again, one of the smartest individuals I know in these markets was highlighting that nobody was paying attention to Apple or Microsoft. Part of the reason that changed was the growth of target date funds mechanically push that money in. But the simple reality was at that point, people were looking at the companies themselves and say, “Hey, wait a second. These margins are largely unsustainable.”

Now, one of the great ironies is, is that when you create this type of feedback loop that advantages the largest companies with a dramatically lower cost of capital, I would actually estimate that it's a negative cost of capital for many of these companies, they're able to do crazy things like subsidize the acquisition of the highest quality labour and talent through the use of stock options.

Stock options, in turn actually need to be exercised that is effectively like them selling shares. Those shares are then mechanically bought by the index investors with no consideration as to value. So, what it does is it actually becomes very much the Soros reflexivity dynamic, where Microsoft and Google and Apple become endowed in a manner that the other lesser companies are not. It actually consolidates real resources into these entities, and makes them more powerful than we think they really should be.

It's truly perverse. If you jump back to that slide that I showed you before, and I want to be very clear. I don't think that this is ultimately going to happen, because the volatility will become so extreme. But if you jump back to slide 11 that shows that exponential curve, that orange line going higher. The easiest way to think about that is as you get to somewhere in the neighborhood of 80% passive, and remember, we're only about 45% right now. Around 80% passive, the Shiller PE would be somewhere around 400 to 500. Sounds great, right? What's the problem?

Ben Felix: You can more easily see an 85% correction, maybe, when these are that high.

Mike Green: That is ultimately one of the things that's really important for people to recognize is, I don't know how to say get out of the way of this thing, when I can realistically look at it and say, “Wait a second, I think it could actually go up another 400%, 500%, 600%, 700%, simply on valuation.

Cameron Passmore: Wow.

Mike Green: Now, I don't think that's going to happen, because I think we're actually approaching the inflection point where the passive has become so large, that it creates its own enemy. And this is where it gets super interesting. Because remember, withdrawals are always a function of asset levels. You think about something like a 401(k) in the United States, you have a required minimum distribution. And again, under lobbying from Vanguard and BlackRock, they've changed the rules to keep assets and 401(k)s longer than they otherwise would have. So, they're doing everything they can to stop this outcome from occurring.

But you're entering into an environment in which a 4% reduction from a 401(k) that is appreciated 300%, 400%, or 500% overwhelms any contribution that people could make. Ironically, actually, 401(k)s went negative in terms of their net contributions back in the fourth quarter of 2018. We immediately changed the rules to address that. But ultimately, we can't fight it that much, because of this dynamic of withdrawals being tied to asset levels while contributions are always going to be a function of income.

When you talk about what are the returns, I have to make a completely conditional and say, “Do we see outflows?” If we see outflows and we unwind a massive fraction of what we've seen so far, and returns will probably be the most negative in history. On the flip side of that, if we don't get to that point, and they continue to change the rules, and they suddenly say, “Hey, wouldn't it be a great idea if we actually had the government put an additional 5% into retirement savings into the S&P 500 for every American?” Well, then the answer is, of course, we're going to see much higher returns and fantastic returns. It really is flow-dependent. It's super complex communication.

Ben Felix: I've seen somebody really good commentary on US economic fundamentals. If we hold flows neutral, just forget about flows. What do you think about US market expected returns based on economic fundamentals?

Mike Green: Unfortunately, there's a whole host of separate issues as it relates to US economic fundamentals tied to the pandemic and the behaviours that we have around the pandemic, and then more broadly, to a discussion of what societal wealth really is. So, when you think about societal wealth, it's very easy to add up the dollar value of all the buildings and all the companies and all the cars we own and the dishwashers we own, et cetera. Those are all certainly contributors to our “wealth.” But remember, that's just an accounting entry. A car is worth $30,000. Well, that's true until you're dying of thirst, and then you're willing to trade your car away for a glass of water.

So, these are all just simply accounting entries. The real value that exists across the world is in human capital, and every corporation gives lip service to this. Our most valuable assets go down the elevator every day. We negotiate against them as much as we possibly can. We try not to pay them reasonably. In fact, if you're Apple, we're going to engage in outright collusion with our peers to make sure that our employees are underpaid relative to the value that they're creating, and we of course, forgive that. But that human capital is really the value.

Unfortunately, because we don't measure that in any way, shape, or form, I'd suggest that almost every metric that we have is deeply distorted. If I look at the human capital component, I would suggest they both in the United States and Canada, we're seeing a significant dumbing down of the general population, as our educational institutions increasingly fail. We're looking at an increasing failure in terms of our healthcare systems and our ability to keep people alive and healthy and in good spirits for an extended period of time. We're seeing a society that is becoming increasingly fractured in the United States and Canada across multiple metrics.

So, all of those should ultimately play into the valuation that we ascribe to assets. Yet, ironically, we don't include those. We're not thinking about that underlying dynamic. On that basis, I would just simply point out that, like the US is far less stable than it's been in periods in the past, and as a result, you should be applying a country discount versus history, we're doing the opposite.

Ben Felix: People investing in US stocks, they shouldn't get out on either the index fund or the economic fundamentals piece, still be an index investor, I guess. But maybe don't count on the recent returns repeating forever when you think about your future.

Mike Green: That is the core issue. And most people have kind of woken up to the giant joke. You can't allow a retirement system to fail, and the US markets have become our retirement system. So, the US government is going to be forced to intervene. Now ironically, if we know that the US government is going to be forced to intervene, that makes us more comfortable investing, therefore, we push prices up higher, which in turn means a larger sell-off is required for the US government to intervene, and how the game plays out. And that moral hazard, I got to be honest with you, is beyond my IQ.

Ben Felix: Man, I think it's beyond everybody's IQ. That's a big one. You just had great commentary on Bitcoin that I've really appreciated. Can you briefly talk about why Bitcoin is not the solution to all of our monetary and fiscal policy problems?

Mike Green: The easiest way to think about this is and it shouldn't be very clear from what I just said that, at the core of any value system has to be belief in the value of human beings and human innovation. The interesting thing about the gold standard, which is really very similar to what Bitcoiners would propose as a new monetary system, that places meaningful constraints on the power of government. You can't magically create gold unless you happen to have control of a supernova. You can create golden supernova. That's awesome.

But then it ceases to work. It's a bit like the quantum calculations breaking Bitcoin. I'm not going to spend that much time worrying about harnessing supernovas yet. But what it does actually have is the advantage that everybody in Bitcoin talks about is the opposite of an advantage. If the price of gold goes up a lot suggesting effectively that there is a shortage of the underlying security, the underlying asset, human innovation can be directed to the production of additional gold to solve that problem to effectively bring the price of money down, so that it's competitive with other assets or other things that you might want to spend your money on.

It's actually exactly what happened at the tail end of the 19th century as William Jennings Bryan in the Cross of Gold speech, which Canadians will be less familiar with, and candidly, Americans who no longer really learn anything in high school are less familiar with. But the simple reality is, is that that cross of gold was sold through technology. We changed the methodologies that we used for extracting gold from gold reserves, using the cyanide process that dramatically increased the quantity of gold, lowered the price of gold, and was able to actually restore some level of normalcy.

Bitcoin doesn't have that capacity. You can work as hard as you want, it's under a fixed release schedule. And as a result, there is no reward to human innovation. That actually is a really messed up system. That's the easiest way to think about it. So, if you actually mechanically run through the gameplay of Bitcoin, it actually consolidates down to an autocratic system in which one entity has all the wealth. That's not a good system.

Ben Felix: Man, that's such an interesting way to explain and think about it.

Cameron Passmore: How will the Bitcoin ETFs change the nature of Bitcoin?

Mike Green: Well, I think the actual irony is that the Bitcoin ETFs expose the true fragility and lack of value in Bitcoin. I know that sounds like I'm effectively searching for the right answer. But remember that gold ETFs own roughly 1% of the global share of gold. Bitcoin ETFs already own about 6% of all the recoverable reserves of Bitcoin. You only managed to get the price to go up about 60%. Stop and think about that for a second. That means that all the other Bitcoiners had to dump their assets onto the unsuspecting boomers who bought into those Bitcoin ETFs in order to keep the price, which should be nearly perfectly inelastic, from rising to extraordinary levels.

The great irony is you've got all sorts of Bitcoin proponents who have absolutely no hesitation around. So, I think the bitcoin price should be a million dollars by the end of the year. People criticize Bitcoin in the response was the best-performing asset of the last decade. This is just silliness, honestly. If anything, the Bitcoin ETFs are as remarkable as they have been, from a flow standpoint, are a testament to how on valuable this asset actually is.

Cameron Passmore: Final question, Mike. How do you define success in your life?

Mike Green: Oh, you got to define success in totally non-financial terms. I've been incredibly lucky. I've got a wonderful wife. I've got three amazing kids and they really are amazing. I like to brag about them, but they are absolutely incredible. I've been gifted relatively good health and the rest of it I'm just not going to worry about.

Ben Felix: Awesome. All right, Mike, this has been a great conversation. We really appreciate you coming on the podcast.

Mike Green: Ben, thank you very much. Cameron. It was a pleasure. I appreciate you guys having me on.

Cameron Passmore: Yes. Great to meet you. Thanks, Mike.

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Participate in our Community Discussion about this Episode:

https://community.rationalreminder.ca/t/episode-302-michael-green-market-efficiency-is-not-the-question-discussion-thread/29382

Books From Today’s Episode:

The Black Swan — https://www.amazon.com/dp/081297381X

Adaptive Markets — https://www.amazon.com/dp/0691135142

Papers From Today’s Episode:

‘How Competitive is the Stock Market? Theory, Evidence from Portfolios, and Implications for the Rise of Passive Investing’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3821263

‘How Competitive is the Stock Market?’ Slides — https://drive.google.com/file/d/1QTxuFI7eK_RJwaV3ncAjX41pEb1anLeM/view

‘Do Active Funds Do Better in What They Trade?’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4624934

‘The Passive-Ownership Share Is Double What You Think It Is’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4188052

‘The Arithmetic of Active Management’ — https://www.jstor.org/stable/4479386

‘Sharpening the Arithmetic of Active Management’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2849071

‘Long Volatility, Asymmetric Alpha, Negatively Correlated Alpha, Convex Crisis Alpha’ Slides — https://www.macrovoices.com/guest-content/list-guest-publications/3860-logica-capital-active-to-passive-for-macrovoices/file

‘The Greatest Story Ever Sold: The Impact of Passive Investment on Markets’ Slides — https://utahfpa.org/images/downloads/Library_Documents/market_policy_presentation.pdf

‘The Inelastic Markets Hypothesis’ — https://www.nber.org/papers/w28967

Links From Today’s Episode:

Meet with PWL Capital: https://calendly.com/d/3vm-t2j-h3p

Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.

Rational Reminder Website — https://rationalreminder.ca/ 

Rational Reminder on Instagram — https://www.instagram.com/rationalreminder/

Rational Reminder on X — https://twitter.com/RationalRemind

Rational Reminder on YouTube — https://www.youtube.com/channel/

Rational Reminder Email — info@rationalreminder.ca

Benjamin Felix — https://www.pwlcapital.com/author/benjamin-felix/ 

Benjamin on X — https://twitter.com/benjaminwfelix

Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/

Cameron Passmore — https://www.pwlcapital.com/profile/cameron-passmore/

Cameron on X — https://twitter.com/CameronPassmore

Cameron on LinkedIn — https://www.linkedin.com/in/cameronpassmore/

‘Yes, I give a fig… Thoughts on markets from Michael Green’ — https://www.yesigiveafig.com/

Michael Green on Substack — https://substack.com/@michaelwgreen

Michael Green on LinkedIn — https://www.linkedin.com/in/michael-green-9a15142/

Michael Green on X — https://twitter.com/profplum99